Updated on 01.20.09

The Intelligent Investor: Stock Selection for the Enterprising Investor

Trent Hamm

intelligentThis is the sixteenth in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the fifteenth chapter, which is on pages 376 to 395, and the Jason Zweig commentary, on pages 396 to 401.

As I mentioned last week, this chapter (and the one preceding it) form what I consider to be the heart of The Intelligent Investor.

What I found most interesting about the previous chapter – Stock Selection for the Defensive Investor – is that Graham basically advocates for index funds if you’re a defensive investor. The interesting part is that Graham wrote that chapter in 1972 – years before index funds appeared for people to invest in. They simply didn’t exist in 1972 – the only mutual funds around at that time were heavily managed by active investors.

This chapter, though, sees Graham talking about individuals who aren’t simply defensive in their investing. How does one seek out and find value stocks, not just ones listed in the S&P 500? Graham really answers that question here.

Chapter 15 – Stock Selection for the Enterprising Investor
So, how do you find a value stock? That’s really the question Graham strives to answer in this chapter.

The first factor to look for is a low price to earnings ratio – information you can easily get from a good stock tracking software like the Yahoo Stock Screener (that’s the tool I use). Graham suggests looking for stocks that have a price-to-earnings ratio of 9 or lower.

Graham immediately points out that simply screening based on a P/E ratio of less than 9 will get you a lot of stocks – and he’s right. I found 909 stocks that had a P/E ratio of 9 or less – a mix of big companies and little ones, ones I’d heard of and ones that I hadn’t.

Graham then suggests five additional factors to screen for:
1. Good financial conditions – assets that are at least 1 1/2 times current liabilities
2. Earnings stability – no losses in the last five years
3. Dividends – some current dividend is being paid
4. Earnings growth – last year’s earnings are more than those of five years ago
5. Price – a stock price less than 120% of the company’s assets

I entered some of these criteria into the tool and found that these factors quickly eliminated hundreds of stocks, leaving me with a much tighter list with companies like Exxon and Chevron to investigate.

Much of the rest of this chapter deals with special situations, most of which Graham encourages people to avoid (“special” issues) or has a lot of caveats about (buying stocks with a stock price lower than the company’s assets – probably meaning the company is in fairly serious trouble).

Commentary on Chapter 15
Zweig actually extracted different lessons from this chapter than I did, which speaks to the density of information in Graham’s writing – and probably indicates why many people have a hard time trudging through the book.

Zweig argues that the biggest lesson here is the value of practice. Graham’s pointers seem straightforward at first glance, but they really only help you find a group of stocks which you’ll have to dig through on your own. The process of digging through those stocks, picking a few, seeing how they do, and learning some of the patterns is something that can’t really be taught in a book – it requires a lot of experience.

How can you get that experience? Zweig strongly encourages people to spend some serious time (he suggests at least a year of practice) using an online portfolio tracker like the one at Yahoo. Study stocks, add some to your virtual portfolio, and watch them. See what works and what doesn’t. If you enjoyed this process and earned a decent return, start investing with real money – but if you just wind up confused and bored, stick with index funds.

Next Friday, we’ll take a look at Chapter 16: Convertible Issues and Warrants.

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  1. One thing to keep in mind is to make sure you’re comparing apples to apples. The PE ratio is good for comparing similar companies, like Exxon and Chevron, but not so good at comparing Exxon to Intel. Different sectors have different historical PE averages. So look for companies that have low PEs in comparison to their nearest competitors.

    I use a combination of Yahoo, Google, and some freeware to manage a “fake” portfolio. I was only down 20% last year. Much of that was in thanks to being heavy in oil stocks at the beginning of the year and selling in the summer.

  2. Blair says:

    Maybe I’m just missing something, but a few of those criteria seem hard to search for in a screener (I used Yahoo and TDAmeritrade’s). Are they called something else?

  3. The Personal Finance Playbook says:

    I have a real portfolio that was down 32% last year. Most of my stocks didn’t do that badly, but were dragged down by a position in Bank of America (that I still hold – it keeps getting worse). I basically have used a variation Graham’s strategies since I read this book and Security Analysis several years ago.

    I keep my retirement in index funds, but I use a buy and hold value strategy in my taxable accounts. I get the best of both worlds – market averages for my retirement, and the intellectual challenges of evaluating stocks in my taxable accounts.

  4. George says:

    Hi Trent. I just happened to write about a new post this morning that directly relates to Chapter 15 of The Intelligent Investor. What a coincidence!

    My post focuses on the special situations and workouts portion of that chapter that everyone seems to ignore. I would strongly suggest that folks strongly consider learning about special situations. While investing in mergers may not be appropriate for individual investors most of the time (however its good right now), there are other special situations ideally suited for individual investors that actually give individuals an edge over the big money on Wall Street.

    My Special Situations Real Money Portfolio that I track on my blog was up over 16% last year. My total return since late 2004 when I started that account is over 70%. I did all this from my son’s Coverdell ESA, even with all the limitations that come with such an account.

    It takes quite a bit of work and mental strength to track and investing in these opportunities, but I think it is well worth it. Those few paragraphs in Chapter 15 on special situations has changed my life and has pretty much formed the basis of my business.

  5. Hallie says:

    I just have to say, I’m so tired of the Intelligent Investor. Will it ever end?

  6. Caroline says:

    So if you hate studying stocks, go with index funds anyway? haha

  7. Isela says:

    When this serie is going to end? Is too much!!!

  8. Lise says:

    This article reminded me that when I was a teenager I had a virtual portfolio through Yahoo Finance – it was something they did called “The Investment Challenge,” or something. It was a lot of fun, but maaaaan did I suck at it.

    Time to get back to it, maybe. I have such a hard time resigning myself to the idea of just putting my money in index funds; I think if you make the average choice, you will always be average.

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